EURO GOVT-Safe-haven paper rallies, Italy suffers before auction

By Marius Zaharia and Kirsten Donovan LONDON, July 12 (Reuters) - German government bond yieldshit five-week lows on Thursday, as minutes of the FederalReserve's June meeting disappointed investors who had bet onadditional U.S. monetary easing, while Italian yields rosebefore a debt auction. Italy plans to sell up to 5.25 billion euros of bonds onFriday, in several maturities. It faces a nervous market, withinvestors concerned about the effectiveness of anti-crisismeasures agreed at a European Union summit last week. In particular, markets worry that Spain may eventually needa full state bailout in addition to the already agreed financialaid package for its banks. That would exhaust the resources ofthe euro zone's rescue fund and leave Italy -- the other countryat the forefront of the crisis -- defenceless. While investors are largely steering clear of high-yieldingItalian and Spanish bonds, demand for assets that are relativelysafe is on the rise. Investors are looking for paper that offersa premium over Germany, but is not perceived as carrying a highcredit risk. Those flows are gaining momentum. Two-year Dutch yields followed their German counterparts into negativeterritory on Thursday, while Finnish, French, Belgian andAustrian yields are not far above the zero mark. "Things are on shaky grounds in the euro zone ... People aremoving up the curve and down the credit ladder hunting foryields. This would be a key theme over the summer," said DavidSchnautz, an interest rate strategist at Commerzbank. Demand for short-dated bonds outside the periphery has alsobeen underpinned by the European Central Bank's cut in interestrates to record lows last week. "The ECB rate cut has had a stronger impact in Germany andparts of the euro zone where markets are functioning normally,"said Lena Komileva, managing director at G+ Economics. September Bund futures were 18 ticks higher at144.82, while 10-year yields were 2 basis pointslower at 1.25 percent, having fallen as low as 1.236 percent,not far from an all-time low of 1.13 percent hit in June. Minutes from last month's Fed meeting, published late onWednesday, showed the world's biggest economy may need to worsenfurther before the central bank takes any more easing steps.

PRESSURE ON SPAIN, ITALY Italian 10-year yields rose 12 basis points to5.92 percent, while equivalent Spanish yields were7 basis points higher at 6.657 percent, showing investors' huntfor yield had limits. Traders said there were not many flows behind any of theperipheral price moves with the 80 cent bid/offer spread on10-year Spanish bonds, the most since late January, reflectingthe lack of liquidity. That compares with 20 cents on French paper of the samematurity, while the equivalent Italian spread is around 30 basispoints but has been widening steadily this month. Italian yields could rise further before Friday's auction asinvestors make room for the new paper, but the generalexpectation is that the sale will be met by decent demand. "Up to 5.25 billion is not an aggressive size for Italy, soI don't have too many concerns" Commerzbank's Schnautz said.